Photo credit: Jeanette Siciliani

In the heated carbon cap and trade debate, the trade part of the formula has received too little scrutiny and discussion.

If we fail to understand how carbon trading works, the risks it creates, and how and why it must be very highly regulated, we will, once again, give Wall Street a free pass to flood the market and our portfolios with innovative and unregulated exotic instruments that could easily turn toxic. That would be to replay the subprime crisis on a larger global scale.

This is no hypothetical crisis: The global carbon trading market is poised to be the world’s next great financial frontier, potentially reaching $3 trillion by 2020. That would make it larger than the subprime market and hedge fund industry before the 2008 financial meltdown. Already, carbon rights are being issued and traded around the world on various exchanges without common quality standards, effective regulatory oversight, almost no transparency, and varying degrees of carbon emission inspection.

While a number of industry analysts compare carbon rights to commodities such as oil or copper, carbon rights are not tangible assets. They are difficult to trace back to a specific issuer or even to a country of origin, making them more difficult to value and thus riskier. Unlike holders of oil contracts who can claim the physical delivery of oil, carbon investors are buying rights to trillions of dollars of, well, air.

Carbon allowances, or permits, authorize a business to emit a set quantity of greenhouse gases (GHGs). Carbon credits, also called offsets, are offered in exchange for not emitting GHGs and for investing in “green” projects or technologies that reduce carbon emissions. Because carbon offset projects are often located in remote places around the world, they are difficult to inspect and thus far riskier.

That hasn’t stopped Wall Street from jumping on the carbon bandwagon. A flurry of under-reported acquisitions, joint ventures and new business initiatives by Wall Street’s top firms is a sure sign of this.

In the past three years, Morgan Stanley, Goldman Sachs, and JP Morgan Chase, to name a few, have developed, acquired or partnered with businesses that are responsible for issuing, registering, auditing, rating, inspecting, certifying or trading carbon rights. Some firms have even created carbon banks that accept carbon rights as collateral.